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How to save tax by investing in mutual funds

What if someone told you that you could create long-term wealth while enjoying tax benefits? Traditional saving instruments with a big lock-in period may come to mind. But there are other tax-saving instruments with a shorter investment horizon that may also give you relatively reasonable returns.

An equity-linked savings scheme (ELSS) is a type of mutual fund product that doubles up as a tax-saving instrument.

What is ELSS (Equity Linked Savings Scheme)?

Simply put, ELSS is an equity oriented mutual fund eligible for tax deductions under the Income Tax Act, 1961. ELSS mutual funds are open-ended equity oriented schemes that invest primarily in domestic company shares and generate growth via capital appreciation for investors. The returns from ELSS funds are linked to stock market performance. To benefit from the tax subsidies, you have to invest in ELSS funds for a minimum of three years.

ELSS funds can be categorized into:

  1. Growth option: ELSS growth option can help with wealth creation. The investor receives the full redemption amount as a lump sum at maturity.
  2. Dividend option: ELSS dividend option give investors dividend income through the course of the scheme. As an investor, you can choose to receive payouts whenever the fund declares dividends, or you could choose to reinvest them.

Tax benefits of investing in ELSS

ELSS mutual funds allow you to save tax under Section 80C of the Income Tax Act, 1961. Investments of up to ₹1,50,000 are eligible for annual tax deductions. Although you can invest more, any excess amount will not qualify for deductions.

The returns generated from ELSS funds incur long-term capital gains tax at 10 per cent if total long term capital gains amount from equity oriented mutual funds/ equity shares are higher than ₹1,00,000 in a year. If you opt for a dividend option, dividends shall be taxable in the hands of the investors and the mutual fund will deduct TDS @10% for resident investor and @20%(plus applicable surcharge and cess) for non-resident investor before payouts. However, the Investor can claim tax credit of TDS deducted at the time of filing of their annual returns.

Despite this, ELSS funds can be considered one of the best tax-saving investment option because of their high return probability, as well as the relatively lower   lock-in period, compared to other alternatives.

How to invest in ELSS?

Just like other mutual fund schemes, you can invest either a lump sum amount or choose a Systematic Investment Plan (SIPs). In case you opt for the later, note that each SIP is considered a separate investment and hence, has an individual lock-in period of three years each. Investors can use a SIP calculator to calculate and estimate the returns on your SIP investment.  Generally, the minimum lump sum investment amount in an ELSS fund is ₹500.

Investing in ELSS is just like investing in other mutual funds. You can opt to contact a mutual fund distributor or choose to invest online.

How to choose an ELSS fund?

Once you have decided between a growth or dividend option, depending on your goals, evaluate different schemes based on their historical performance. Though this is not a guarantee for future performance, it can be a fair indicator. Also, check for consistency of returns. Other criteria to consider would be age and fund size. A larger fund sustaining over a period of time indicates higher trust among investors.

However, you should also check other indicators and pick a fund most in line with your financial objectives rather than going with the market trend.

Things to consider while investing in ELSS (Tax Saving Mutual Funds)

When you invest in ELSS tax-saving mutual funds, there are certain things you must keep in mind before making the decision:

  1. Goals: Outline the reason to invest in ELSS funds. In addition to saving tax, the returns can also help you meet other goals like going on vacation or purchasing a vehicle.
  2. Risk: ELSS funds invest mostly in equities, meaning they are risky instruments. Returns are not guaranteed. Therefore, ensure you have the risk capacity to invest in them.
  3. Tax exemption: ELSS investments are eligible for up to ₹1,50,000 tax deductions a year under Section 80C of Income Tax Act. However, the section also includes other options like provident fund and life insurance policy. If you have other claims, the entire ELSS amount may not be eligible for deductions.
  4. Time horizon: ELSS funds cannot be redeemed for at least three years. Make sure you do not need the funds during that period.

What to consider before investing in ELSS?

  • ELSS are equity oriented mutual funds that double up as tax savers.
  • When you invest in ELSS, up to ₹1,50,000 per annum can be claimed as tax deductions under Section 80C of the Income Tax Act.
  • Returns (from equity oriented mutual funds and equity shares) over ₹1,00,000 will attract long-term capital gains tax at 10 per cent .
  • The lock-in period is three years, but you can extend your investment for longer.
  • Although the potential for returns is high, ELSS is still a risky investment.

Takeaway

Equity-linked savings schemes can be one of the better options that could help to build wealth while also saving you taxes. However, just like any other investment, do your research, evaluate your financial goals, and ensure you know the features before you go all in.

Next To Come: What Are the Tax Implications On Mutual Funds?